Commentary and musings on the complex, fascinating and peculiar world that is securities regulation

Wednesday, April 13, 2011

Fed Governor Says List of Hedge Funds and Mutual Funds Deemed Systemically Important under Dodd-Frank Should Be a Short One

The initial list of hedge funds, mutual funds, and other non-bank financial firms designated as systemically important by the Financial Stability Oversight Council and thereby subjected to heightened supervision should not be a lengthy one, said Federal Reserve Board Governor Daniel Tarullo. In recent remarks, he noted that the structure established by Congress in Dodd-Frank suggests that the standard for designation of hedge funds and other non-bank firms should be quite high. The most obvious pre-crisis candidates for designation as systemically important, the large investment banks, have either become bank holding companies or gone out of existence. Any additional non-bank financial institutions so designated should present some combination of what Gov. Tarullo calls a domino effect or a fire sale effect involving the direct consequences of the firm’s failure.

Section 113 of Dodd-Frank authorizes the Council to designate hedge funds, mutual funds and other firms systemically important enough to pose a threat to financial stability. Dodd-Frank requires the FSOC to consider a lengthy list of factors when making this determination, which collectively emphasize the importance of various attributes of size and interconnectedness. The FSOC's designation function is governed by administrative law features such as notice, opportunity for hearing, a statement of reasons for decision, and judicial review.

Governor Tarullo has crystallized the laundry list of factors the FSOC must consider into four main effects of failure. The first is the classic domino effect, whereby counterparties of a failing firm are placed under severe strain when the firm does not meet its financial obligations to them. Their resulting inability to meet their own obligations leads, in turn, to severe strains at their other significant counterparties, and so on through the financial system. The second is the fire-sale effect in asset markets when a failing firm engages in distress sales in an effort to obtain needed liquidity. The sudden increase in market supply of the assets drives down prices and the need to sell assets to meet immediate liquidity needs is spread by margin calls and mark-to-market accounting requirements to many other firms as well.

The third is a contagion effect, whereby market participants conclude from the firm's distress that other firms holding similar assets or following similar business models are likely themselves to be facing similarly serious problems. The fourth is the discontinuation of a critical function played by a failing firm in financial markets when other firms lack the ability to provide ready substitutes.

The domino and fire sale effects, which the Governor believes should be applied to hedge funds and other non-bank firms in determining their systemic importance, are largely a function of the interconnectedness of the distressed firm with other large firms, either through direct counterparty exposures or through common exposures of the firm's balance sheet with those of other firms. Typically, these first two effects will scale with a firm's size as well.

In contrast to these first two effects, the contagion effect is not necessarily a function of size at all. The run on money market mutual funds began in September 2008 after the "breaking of the buck" by the Reserve Primary Fund, he noted, less because of its size than because of what its vulnerability told investors about the balance sheets of other funds. This distinction is very important, emphasized the Fed official, since the contagion effect can plausibly originate in a very large number of firms, depending on circumstances in financial markets as a whole.

Indeed, the failure of almost any financial firm could bring about systemic problems if markets believe that failure reveals heretofore unrecognized problems with one or more significant classes of assets held by many financial actors, especially where the assets are associated with considerable degrees of leverage, maturity transformation, or both.

The fourth effect, relating to an essential role in financial markets, also need not be a function of size, although it is surely related to a particular kind of interconnectedness. This factor may have little to do with the assets of the firm and could instead rest on the firm's status as a node through which an important class of financial transactions flows.

Congress could have made every non-bank financial firm with more than $50 billion in assets subject to prudential standards and consolidated supervision just like it did for banks, observed Gov. Tarullo, but it chose not to do so. Instead, it required an administrative determination on the basis of a list of factors which, though not by its own terms exclusive, leans heavily toward characteristics associated with the first two kinds of systemic effects, domino and fire sale.

The potential for systemic risk from contagion should not be part of the systemically important designation for hedge funds and mutual funds, said the Fed officer, since contagion effects really reflect the potential failure of an asset class or business model more than a firm. These risks can be more effectively addressed head-on.

The fourth factor involves the special case of a firm whose failure would bring about the removal of a critical function in the financial system, but that doesn't otherwise have the size and asset composition to elicit a domino or fire sale systemic effect. Gov. Tarullo believes that, to a considerable extent, this issue is addressed in Title VIII of Dodd-Frank, which calls for the separate designation and regulation of systemically important financial market utilities.

The Governor also noted that the universe of firms whose failure would produce the domino and fire sale effects will vary. When Drexel, Burnham failed in 1990, there were consequences in financial markets, but nothing approaching a systemic problem. But the failure of Lehman Brothers in 2008 sparked a conflagration in the financial markets.

At some point of sufficiently high stress, he reasoned, the conceptual distinctions among the first three kinds of effects may in practical terms elide, since even a smaller firm could be the ``proverbial straw that broke the camel's back.’’ But for purposes of designating firms under Section 113, he added, it makes little sense to hypothesize all such crisis moments since under this reasoning virtually all firms pose systemic risk. But it may be appropriate to assume a moderate amount of stress in financial markets when considering the first and second kinds of effects that would follow a firm's failure.